Phelps Company leases a building to Walsh, Inc. on January 1, 2020. The following facts pertain to the lease agreement.

1. The lease term is 5 years, with equal annual rental payments of $4,703 at the beginning of each year.

2. Ownership does not transfer at the end of the lease term, there is no bargain purchase option, and the asset is not of a specialized nature.

3. The building has a fair value of $23,000, a book value to Phelps of $16,000, and a useful life of 6 years.

4. At the end of the lease term, Phelps and Walsh expect there to be an unguaranteed residual value of $4,000.

5. Phelps wants to earn a return of 8% on the lease, and collectibility of the payments is probable. This rate is known by Walsh.

Instructions

a. How would Phelps (lessor) and Walsh (lessee) classify this lease? How would Phelps initially measure the lease receivable, and how would Walsh initially measure the lease liability and right-of-use asset?

b. Using the original facts of the lease, show the journal entries to be made by both Phelps and Walsh in 2020.

c. Suppose the entire expected residual value of $4,000 is guaranteed by Walsh. How will this change your answer to part a?

d. Assume the same facts as part c, except the expected residual value is $3,000. Does your answer change?